This blog launched in the Spring of 2011.
Post #4 was Why you need F-you money. Post #6 presented The Simple Path to Wealth to get you there and Post #9, What we own and why we own it, told you how we keep ours. Almost everything else on the subject of money has been an elaboration of the tools and ideas introduced in these three.
One of the most gratifying aspects of writing is reading the comments and, on occasion, being able to answer a question or two. Some of the best material is in the comments section.
The Simple Path, and indeed the blog itself, grew out of a letter I wrote to my then 19-year-old daughter. She doesn’t share my fascination with finance and investing. Most people don’t. But in this modern world of ours, money is crucial. I wanted her, and now you, to have simple but highly effective investing tools. The ideas here are designed to provide a lifetime of successful investing with minimal effort and cost. They are for those who have better things to do with their time. The cool thing is, that when it comes to investing, the correct minimal effort actually produces better results than labor intensive strategies.
Of late I’ve been toying with the idea of a post that showed what rolling out and living with this approach might look like. All I needed was to create a fictional young investor about to begin their journey. That’s when reader KLR saved me the effort and provided the motivation by posting a comment/question here.
For the purposes of this post, I emailed KLR with some follow-up questions. I’ve taken the liberty of adding his responses into his original note below, but all the words are his.
His note and my reply follow.
I stumbled onto your blog this week and have caught up with all your money posts. I would like to say that your guidance has probably saved me months of research and lots of frustration. Thank you for the great topics, but I am now trying to figure out my plan and my head is spinning.
I’m 26 and have recently graduated from college, and decided to get my financial life in order. Luckily, I was able to find a great job and have no debt. I am working on saving up my emergency fund (roughly 24% of my income is going into it) and now focusing my efforts on investments.
I was also lucky that my grandparents seeded an investment fund for all of the grandchildren when each was born. It has been managed by a financial advisor for years, and your posts have confirmed my thoughts that I can do better. It currently has around $35,000 in it in 12 different mutual funds.
I talked to my grandmother and she doesn’t remember the exact amount that started my account. Whenever a new grandchild was born, she would put a starting amount in equal to what was in the older children’s accounts. The earliest records I have is from 1994. At the start of that year, there was approx. $6700 in the account and a $1000 was added by my grandparents each year until the it hit around $25,000. In 1994, the funds were half stocks and half bonds (my grandfather grew up during the great depression and didn’t really trust full stocks).
Next June, I will be eligible to enter my employer’s 403(b) plan and also a pension plan. I am able to put 3% of my income into the 403(b) plan and they match with 2.5%. It looks like I will be able to enroll in Vanguard’s total stock market index fund. There is also an optional traditional IRA plan that I can contribute up to the maximum allowed by the IRS. It seems that after learning more about all of this, the 5.5% of my yearly salary into my 403(b) is nowhere the maximum allowed by the IRS, which is a little discouraging.
I make $70k per year before taxes. Right now I’m saving 24% of my pay. My goal is to keep it at 20% or more, but realize I might have to drop to 15% if other commitments arise. I haven’t really thought about when I want to retire. It would be great to retire early, but I have not officially set that goal yet. I just know it is important to get everything lined up to get ready for retirement and that is what I am trying to do now.
I don’t think I’m going to do the optional IRA account and instead do a Roth IRA on my own. What is your suggestion on getting rid of my financial manager and all the mutual funds and buying into VTSAX? I don’t fully understand the tax implications that are involved in that. Correct me if I’m wrong, but $5000 would go into the Roth and the rest into a traditional account. I think I know the answer, but do you think it is fine to have the investments in my 403(b), Roth IRA, and my regular account in VTSAX?
What is the best way to contribute to my funds? After I get my emergency fund built up and my money transferred to vanguard, I will have around $1000 per month. Do I put that in each month or wait to put in larger amounts. I have heard of dollar cost averaging, but haven’t looked into it too much. Thanks again for your advice and time.
Sorry for the long post, but any assistance would be greatly appreciated.
He also kindly added a link to his employer’s benefits page, but asked that his employer’s name remain confidential. Looking at that page, what he refers to in his note as “an optional traditional IRA plan” is an SRP.
….glad you found your way here and delighted to hear you’ve found some value. Plus you’ve given me a great opportunity for another post!
You mentioned that you’ve read thru the money posts so we can go forward assuming that base of knowledge. For those newer readers following along I’ll provide links to some relevant posts, as I did above.
But before we get started, some congratulations are in order. No, not for you.
For your grandparents!!
They deserve big time major league kudos. Please tell them I said so.
The fact that they have provided this seed capital for you and their other grandchildren tells me several things. They have resources, and that means they are fiscally responsible and effective in their own lives. They are generous. And, considering your questions and plans, clearly they have passed it on to their descendants. If you haven’t already, take them out to dinner and raise a toast in their honor. Even if you have, do it again.
In managing this money it is no surprise they choose an investment advisor. As you know, I don’t like investment advisors, but back in the day there weren’t many options and given the results you describe, they chose well. Still, thanks to Jack Bogle and with Vanguard Index Funds you are ready to move on.
Looking at your situation we have a great base upon which to build:
1. 35k in capital to start.
2. 70k salary and you are saving 24% (17k annually) of that for your emergency fund.
3. You want to target saving about 20% going forward, or 14K. I’ll try to persuade you to increase that.
4. You’ve landed a good job with an employer that provides some excellent retirement plan options.
5. No debt.
6. You’re not sure about retirement yet, no surprise at age 26, but you recognize the importance of F-You Money. We’ll focus on getting you there.
7. You want to know how to contribute to your investments going forward and about Dollar Cost Averaging.
Mmmm. Looking at that list, you deserve some kudos too!
Let’s talk first about what investment to choose.
Fortunately, with your employer’s benefits plan Vanguard is an option.
You are leaning toward Vanguard’s Total Stock Market Index Fund and you are spot on. This is where we’ll put all of your investments. You are in the Wealth Building phase of your life and this is the right tool for the job.
There are three options to owning this fund: Admiral Shares, Investor Shares and as an ETF (Exchange Traded Fund). VTSAX is the Admiral version and provides the lowest cost, but has a 10k minimum. Investor Shares, VTSMX, holds the same stocks, but with slightly higher costs and a 3k minimum. Use Admiral whenever you can and Investor if you need to as a start. You can switch to Admiral when you clear the 10k hurtle.
This one fund will give you a portfolio that owns virtually every publicly traded company in the USA. Since many of these have extensive international operations, you also have international market exposure. With this one investment you’ll have broad diversification in the most powerful wealth building asset of all: Stocks. This allocation of 100% stocks is considered a very aggressive and that’s what we want for this phase. But be warned, as you know from reading my series on stocks you can expect a wild and gut wrench ride. But you’re going to stick to your plan, keep investing and tough it out. You have decades ahead.
At some point you’ll start thinking about retirement.
Maybe when you’re 65 or maybe when you have F-you money around 35 or so. Whenever the time comes, as you approach that phase you’ll want to consider diversifying into other asset classes. This is where Mrs. jlcollinsnh and I are in our lives and I’ve written about what we own and why we own it. But right now you are in the wealth building phase. Stocks are where you want your money and VTSAX is how you want to own them.
Next let’s look at the various Investment Buckets you have available and discuss how to allocate your VTSAX investment. Basically you have four and in each will be a separate account, all invested in VTSAX/VTSMX. In order of desirability they are:
1. 403 (b). Since you work for a university you have a 403 (b) and your employer had the wisdom to engage Vanguard as one of the plan providers. (Readers working for companies have much the same but it is called a 401k.) You’ll contribute 3% of your salary, which will be tax deferred, and your employer matches 2.5%. That’s free money! That makes this option #1.
Since your total for the first year will be about $3850 you’ll probably start with VTSMX, but check. Because it is a 403 (b) plan, and by definition long-term investment money, Vanguard might waive the 10k minimum for VTSAX.
2. Roth IRA. You should put the maximum allowed into your Roth each year: $5000. While you get no immediate tax deduction with a Roth, when you retire all distributions are tax free. That includes everything your Roth earns over the decades. Very cool deal. Everyone should have a Roth, especially when you are young and in a low tax bracket. Rather than using part of your 35k stake, I suggested you fund your Roth with money from your earnings. You’ll be doing this every year.
3. SRP (Suplemental Retirement Program). This is an additional program your employer offers and the IRS allows you to contribute up to $17,000 each year. No company match, but you get a tax deferral on the contribution. It is a very attractive benefit.
4. Ordinary Bucket. This is what I call regular investments made outside any tax advantaged bucket like the first three. You’ll pay taxes on the dividends and capital gains distributions but, unlike tax advantaged accounts, your money is available anytime with no penalty. This is where your 35k is now and when you move it to VTSAX that will still be the case.
When you sell the 12 funds you currently own, assuming they have appreciated in value, you will owe a capital gains tax. Don’t lose sleep over this. Cap gains taxes are low at the moment.
A bit later we’ll talk about how much goes into which bucket, but first…
…let’s discuss a couple of things:
1. Your savings rate is currently 24% as you are building your emergency fund, and you plan to reduce this to 20%. Compared to the average American these percents are excellent. Compared to where you want to be, you should consider doing more. 50% is my suggestion, but others more committed to having F-you money commonly reach for 70-80%.
You are already stepping out of the norm by being debt free, saving and investing. You are employed, young and childless. Never will you be in a stronger position to take it to the next level. At the very least, avoid “lifestyle inflation” by pledging that any salary increases will go towards your investments. Do this now and in the future your problem will be how to spend all the money your money earns for you.
2. Your emergency fund, if you are following standard investment advice, is likely too large. Keeping a few grand around is fine, but if you are trying for six months of income (35k in your case) you are tying up money that should be working harder for you.
OK, with all that under our belt let’s run some numbers and look at specifics.
Option #1, 24% savings rate.
You start with the $35,000 from your grand parents. Move that immediately into VTSAX. Pay the cap gain tax, if any. On average over time the market returns 10-11% annually. At that rate your money doubles about every 7 years. By the time you are 61 it will have doubled 5 times. A quick back of the envelope calculation shows you’ll have around $1,120,000. Without adding a single penny. Wait till you’re 68 and it’s $2,240,000. That’s the power of compounding. Did I mention you should take your grandparents to dinner?
If you add to it as you go along, as you’re going to, and the results become even more powerful.
Already I can hear the naysayers howling: From 2000-2008 the market wasn’t anywhere near a 10% return. True enough. But from 1982 until 2000 returns blew past 10% and averaged around 18% per year. Since the Spring of 2009 the market has just about doubled. The fact is, in any given year, it is exceedingly rare that the market will specifically return 10-11%. But that’s not what we’re saying. 10-11% is the average we can expect over a 20, 30 or 40 year span. Each individual year will vary wildly. Which, as we’ve said before, is why you gotta be tough.
Moving on, if we use your current savings rate of 24% you’ll have $16,800 to invest each year.
Your 403 (b) gets 3% of your $70,000 salary. $2100. (The university will add 2.5%, $1700, but that’s in addition to your 24%/16.8k investment money.) This will go into VTSMX and then to VTSAX when the balance goes over 10k.
Your Roth IRA gets $5000, also in VTSMX and moved to VTSAX once over 10k.
So between the 403 (b) and the Roth we’ve accounted for $7100, leaving $9700 to invest. Because you have the 35K, I’d put this into VTSAX in the tax advantaged SRP (Supplemental Retirement Program). For somebody without anything outside of tax advantaged accounts, I’d split it so some money is available without penalty in an “ordinary bucket” account.
Option #2, 50% savings rate.
Again you start with the $35,000 from your grandparents, but now from your salary we have another $35,000 each year to invest.
As before your VTSMX 403 (b) gets 3% of your $70,000 salary. $2100. This is the max you can contribute. (The university will add 2.5%, $1700, to that but that’s in addition to part of your 24%/16.8k investment money.) This will go into VTSMX and then to VTSAX when the balance goes over 10K.
Your VTSMX Roth IRA also still gets the max at $5000.
So between the 403 (b) and the Roth we’ve again accounted for $7100, but now leaving $27,900 to invest. With this we can take full advantage of all the options your employer offers and max out the tax advantaged SRP (Supplemental Retirement Program) with $17,000 into VTSAX. That leaves $10,900. We’ll add that to VTSAX in the Ordinary Bucket and build on $35,000 seed capital your grandparents so generously provided.
Psst. He’s going for Option #2.
Finally, let’s talk about how these contributions will happen.
To begin we’ll take a look at Dollar Cost Averaging. Simply speaking the idea behind DCA is that if you invest a given amount of money on a regular basis over time the effect will be to have bought shares at a lower average price. This is because when prices are high your money will buy fewer shares than when prices are low.
For example, suppose we decide to invest $100 per month in XYZ Enterprises:
- Month #1 with XYZ trading at $10 per share our $100 buys 10 Shares.
- Month #2 with XYZ trading at $5 per share our $100 buys 20 Shares.
- Month #1 with XYZ trading at $15 per share our $100 buys 6.67 Shares.
- Month #1 with XYZ trading at $7.50 per share our $100 buys 13.33 Shares.
If my math is correct, we now own 50 shares of XYZ @ $8 per share on average. Thus we have avoided paying $10 a share had we bought all at once. Of course, some will argue that had we waited a month we could have picked up the shares at $5 each. But this would have required our knowing they’d drop to that level (before bouncing up to $15) in our example.
There is much debate on the usefulness of DCA and for any readers who might care you can click on the link. Moreover, it only really applies if you have a lump sum to invest. My preference, with a lump sum, is to invest all at once. I can’t be sure prices will move down to my advantage and if I DCA the money waiting is sitting in cash (or some other asset class) effectively altering my plan. I want my wealth building phase to be fully engaged with the most powerful asset class of all: Stocks. This is what I am suggesting for your lump sum of 35k.
Like most people, you’ll also be investing as you can over time. Effectively DCAing. You’ll be doing that with your 403 (b), SRP and Roth accounts, as well as any additional money you add to your Ordinary Bucket VTSAX initially filled with the 35k.
The beauty of your 403 (b) and SRP accounts is that once you set them up, the contributions will happen automatically. The Roth and Ordinary Bucket VTSAX will require you to expend a bit more effort. You’ll either have to add to them just like you pay your bills or you can set it up with Vanguard to have the money automatically transfer. Automatic’s what I’d do.
There you have it. Follow this….
…and before you know it you’ll have F-You money and working will be an option. By the time you are your grandparents’ (did I mention you should take them to dinner?) age you will have provided seed money accounts for your own grand kids, continuing the cycle. Around then you might also consider learning how to give like a billionaire.
Enjoy the journey and check in once in a while and let us know how it’s going.